Studies suggest illogical behaviour offers opportunity

Friday 4th May 2001

By David van Schaardenburg

"Do I stay or do I go?" This is the key question facing portfolio investors after the worst decline in global equity asset values in over 30 years (see bar graph). In the year to March 31, 2001, the best-known global share index, MSCI World, fell 21.6%.

Investors receiving reports detailing their investment returns to March 31 will, if they had diversified offshore, show a modest or negative return for the past quarter and year.

Behavioural finance studies from past periods indicate the historic trend for the average investor is to sell once the market has fallen, especially when they have experienced negative returns, and conversely invest new sums when markets have either risen strongly or are in a period of euphoria.

Just as the optimism of rising markets is sometimes irrational so, too, can be the negativity that normally prevails when equity markets are in one of their periods of decline. The fall in a company's share price will more often than not have no meaningful impact on its business operations or future growth potential.

Do people use Microsoft software products more or less when its share price falls? As you would expect, there is no correlation between the two.

However, when Microsoft's share price falls, new investors are essentially getting the same financial prospects at a price lower than previously - a situation most shoppers would refer to as a "bargain."

If consumers like bargains why would investors act in a contrary manner in selling shares even if they represent better value for money?

Two reasons - they are either acting illogically or they anticipate the bargain will become bigger in the future as share prices continue to fall.

While there is little merit in attempting to have a debate with the irrational investor, the more important question is: "Will global share prices continue to experience further declines?"

While investment markets will continue periodically to experience volatility, the surprise cut in US interest rates on April 18 led to a 3.9% rise in the US equity market.

This single response provides a demonstration of:

the potential impact on equity values from lower interest rates; and
the armoury available to policy makers to combat the trend to slowing economic activity.

In addition to lower interest rates, the US authorities are seeking to legislate cuts in income tax rates.

This combination can be expected, over time, to boost business plus consumer confidence, and subsequently economic activity.

These trends will eventually move corporate profitability back into a rising path.

As is often the case, recent past market returns actually provide contrary signals to investors.

When markets go down there are, in fact, more reasons to buy (not sell) and the converse when markets rise unduly.

Shares around the world today represent better value than a year ago.

Policy makers are also actively seeking to stimulate economic and corporate profit growth. These are both strong buy as opposed to sell signals. For the long-term portfolio investor this means not only should you stick to your strategy but you should also be looking to invest spare cash.

David van Schaardenburg is executive chairman of FundSource (formerly IPAC), the investment strategy and funds management research company

Comments from our readers

No comments yet